Are Token Assets the Securities of Tomorrow? We Often Equate Crypto- Assets with Bitcoin Or Other Cryptocurrencies

Are token assets the securities of tomorrow? We often equate crypto- assets with bitcoin or other cryptocurrencies. But “crypto-asset” is actually a much broader term covering security tokens and new disruptive models for the security value chain from issuance to custody & settlement. Are token assets the securities of tomorrow?

Content

Executive summary 04

Let’s call a spade a spade–vital first steps 06

Are tokens securities? How should Security Token Offerings (STO) be conducted? What does the future hold for the security value chain? 10

What is the status quo in terms of the regulatory framework? 13

Transformation of the security value chain from niche FinTech initiative to disruptive force re-shaping the securities business model 16

Security tokens and the security value chain 18

Security tokens—what will the securities landscape look like in the future? 22

Conclusion 24

03 Are token assets the securities of tomorrow?

Executive summary

When we talk about crypto-assets, the first idea that comes to mind is bitcoin, followed by other token currencies. But the term “crypto-asset” covers much more than just crypto-payment.

At present, we lack a shared definition of After 10 years spent getting to grips with Depositories Regulation (CSDR), Settlement the term crypto-asset, but this is essential divergent regulatory frameworks, securities Finality Directive (SFD), European Market if we are to properly define and understand market stakeholders are at a pivotal state Infrastructure Regulation (EMIR), Market what does and does not qualify as such. in their transformation in which they must Abuse Regulation (MAR), UCITS, and This is important because different types balance a need for transparency and risk AIFMD. However, doing so will open up new of asset are treated differently from an mitigation in relation to their environment business opportunities throughout the operational and a regulatory perspective. against the need to make the process as security value chain. efficient as possible. A global consensus has emerged in relation to dividing crypto-assets into Are security tokens the answer to this three main archetypal assets: payment/ conundrum? Are security tokens the exchange (e.g., bitcoin and equivalents), securities of tomorrow? In our view, the security (investment components including answer is yes. The security token is the ownership and promise of future cash security of the future. European and local flows), and utility (access to specific authorities now acknowledge that DLT products, services or protocols). These platforms and security tokens can provide assets can also be combined in various clear added value in terms of transparency, hybrid forms. efficiency and enhanced reporting/ oversight. However, taking advantage of This paper aims not only to clarify what is this opportunity will involve adopting two meant by the term crypto-asset, but also main principles. to assess current solutions and the related regulatory framework. We will be providing Playing by the rules of the game an overview of the business opportunities Security tokens can be offered (through and impact of using security tokens within security token offerings—STO) and existing a Distributed Ledger Technology (DLT) assets can be tokenized in a way that ecosystem by considering issues relating ensures that they qualify as transferable to the primary market (issuance/notary securities as defined under MiFID. This will services), trading and post trading (clearing entail complying with requirements derived and settlement), and safekeeping and from other European regulations such as custody services. the prospectus directive, Central Securities

04 Are token assets the securities of tomorrow?

Of course, it is possible that a security services), and developing new products European and local regulators have token value chain will emerge on DLT and security offerings on the primary and conducted several consultations to assess platforms with little or no regulatory secondary markets (AIF, digital property, the full scale of these questions (e.g., oversight, as we saw with crypto-payment digital art, etc.). ESMA Securities and Market Stakeholders platforms. From our point of view, security Group). They have also relied on advice tokens can only secure a sustainable To gain greater stability on the security reports (ESMA, EBA), local taskforce presence in the industry if they are market and to ensure a less risky initiatives (FCA, AMF), and developed a underpinned by a well-defined regulatory framework on the security payment side, dedicated legal framework (Luxembourg, framework. This is a prerequisite if we Central Bank Digital Currency (CBDC, also Switzerland, Italy…). Market participants, are to establish a trusted, transparent, called digital fiat currency) and Stablecoins infrastructure operators, and new entrants and resilient environment that serves have recently emerged as potential are monitoring trends closely and have regulators and investors alike. solutions to act as the commercial bank launched or are working on projects aimed and central bank monies of the future at establishing the security token as a new Thinking outside the box Security DLT market. asset class in the security value chain. To fully leverage DLT and security token opportunities, we need to view DLT not There are obviously still many open This paper aims simply as a new type of “database” but questions that will need to be answered rather as a new way to organize the if security tokens are to enter the not only to clarify security value chain from issuance to mainstream. Widespread use of the custody. This is clearly one of the main technology is likely to be particularly what is meant by challenges we face, as we will have to break dependent on the following three issues: away from the sequential centralized value the term crypto- chain model and embrace a distributed • Interoperability between ledgers leger model where participants can access asset, but also to the same information at the same time. • Delivery versus payment in central bank money and the ability to settle via DLT assess current This will entail defining a new security value chain, roles, and responsibilities • The legal framework in relation to AML solutions and the (trustee agent, insurance for digital wallets, KYC, custody, safekeeping, and redefining etc.), redefining existing roles (issuance, what counts as a security related regulatory notary services, safekeeping, and custody framework.

05 Are token assets the securities of tomorrow?

Let’s call a spade a spade– vital first steps

Despite a constant stream of publications • Data distribution: Multiple participants The financial about blockchain and other crypto- can keep a copy of the ledger and are instruments, a shared understanding of able to read and access the data. This industry’s what is meant when these terms are used relies on the power of the internet. has yet to emerge. Given that this is the preference for case, our first step must be to provide our • Decentralized decisions/control: Based own definitions of the various terms and on agreed processes and monitoring, permissioned concepts and our understanding of how every participant can update and accept they interact with one another. any update carried out by another ledgers makes participant. Distributed Ledger Technology sense given the The term Distributed Ledger Technology • Cryptography: Defined as the science (DLT) refers to the technological of transforming information into a form highly sensitive infrastructure and protocols that enable that is impossible or infeasible to forge, simultaneous access, validation, and duplicate or erase without a secret key. nature of the record-keeping by multiple stakeholders in DLT platforms can securely identify all an immutable manner across a distributed participants, confirm data, and generate data and the fact and decentralized network. The term can consensus1. be broken down into three key notions: that reaching • Automation/programmability: “Distributed” refers to the fact that the data Computer-coded automation ensures a consensus is shared and may be accessed by multiple that contractual terms and conditions participants instead of being stored in a (e.g., interest payments on bonds) are is quicker & single ring-fenced database. automatically implemented. In DLT, this A “Ledger” is a form of database that (like is achieved through the use of smart easier within any other database) contains a record of contracts. Smart contracts are programs who owns what, or who did what, and can that send and receive assets and permissioned be used to store range of datasets. The information when certain conditions are information is disseminated among the met. ledgers. participants in a secure and synchronized way. Each participant can initiate, confirm, The terms blockchain and DLT are often and update information in a ledger. wrongly used interchangeably. In fact, blockchain is just a way of organizing and The word “Technology” refers to the recording data on a DLT platform. Bitcoin protocol that enables the database to work was the first successful DLT platform that in a distributed and decentralized way. proved itself to be sufficiently robust from both a conceptual and a technological As the technology is still in its infancy, there standpoint. is no standard form of DLT. There are many types of DLT platform, but they all have four What made bitcoin ground-breaking was characteristics in common: the fact that it combined technologies

1 BIS, “Distributed ledger technology in payment, clearing and settlement”, Committee on Payments and Market Infrastructures, 2017, https://www.bis.org/cpmi/publ/d157.pdf 06 Are token assets the securities of tomorrow?

Current system Dlt system

• Central authorities (bank, Fed, notary, escrow, • Distributed network of computers (nodes) etc.) transfers actual value between two parties that maintains a shared source of information

• Multiple intermediaries and record-keeping • Transaction data is immutable. Trust is enabled are required to facilitate transfer of assets and by cryptographic algorithm create trust

used in DLT and built a distributed network permissioned ledgers makes sense given participants in the system without a central and trusted authority: the highly sensitive nature of the data its main selling point is that it is open to and the fact that reaching a consensus is • Contains a certain and verifiable record anyone wishing to participate and maintain quicker and easier within permissioned of every single transaction ever made identical copies of the ledger. This model is ledgers. This removes two major concerns: referred to as a “public” or “permissionless” The anonymous nature of the participants • Can be public, permissioned, ledger. and the high cost of running the system. or private.

Nevertheless, most of the DLT platforms DLT in a nutshell that have been developed for the financial • A record, or ledger, of digital events industry in recent years are based on a “distributed” between unlimited parties model of restricted access to known and approved parties. • Can only be updated by an algorithm The financial industry’s preference for consensus of a majority of the

07 Are token assets the securities of tomorrow?

Crypto-assets: a closer look at the value that can be stored and transferred two parties without the need for a central terminology within a distributed ledger (DLT). intermediary.

A crypto-asset is a type of private asset A token is an object that represents Today, we recognize three main archetypes whose perceived or inherent value is something else, such as another object of crypto-asset/token: at least partially derived from its use of (either physical or virtual). cryptography and distributed ledger or similar technology2. In other words, the Therefore, in our context, a token is the asset is digitally recorded and provides digital representation of an asset based a graphically secured representation of on DLT. It can be transferred between

Payment/ Exchange tokens Security tokens Utility tokens

Payment/ Exchange tokens are a Security (investment) tokens may Utility tokens provide token holders means of payment for goods or provide to the holder, the ownership with access to a function provided services of assets and entitlements to use directly by the token issuer them, dividend distribution (profit sharing) and voting rights

Buy a pair of shoes in Bitcoin on OpenBazaar platform Digital investment Vehicle (DAO) Filecoin provide token holders available provide holders with voting rights space on computers to store data and share future profits

2 FSB, “Crypto-asset markets: Potential channels for future financial stability implications”, Glossary, October 2018. bis.org/cpmi/publ/d157.pdf

08 Are token assets the securities of tomorrow?

thought of as assets providing rights Crypto-assets are more than just bitcoin such as ownership, payment of a specific sum of money (dividend) or entitlement or other payment tokens. At present, there to a share in future profits or cash flows. Security tokens may qualify as transferable are three main archetypes of crypto-asset securities or financial instruments under the EU’s Markets in Financial Instruments (payment, utility, and security (investment) Directive (MiFID II). Just as depository receipts are certificates representing token), which each have specific business securities, security tokens are the digital representation of existing securities such purposes, stakeholders, and related as equities, debt instruments, funds, etc. regulatory frameworks. Some tokens may fall into several categories (e.g., investment and payment tokens). These are what we refer to as “hybrid tokens”.

Payment/exchange tokens Utility token Crypto-assets in a nutshell Initial Coin Offerings (ICO, also called “token ICOs can be used to sell tokens that provide Crypto-assets are more than just bitcoin sales”) are launched to create a crypto- investors with a functional advantage or other payment tokens. At present, there payment instrument. Issued tokens are other than the ability to pay for external are three main archetypes of crypto-asset meant to function as a means of exchange, goods or services. Some utility tokens (payment, utility, and security (investment) a unit of account or a store of value. The can be redeemed in exchange for access token), which each have specific business aim is to ensure that it is possible to pay to a specific product/function (storage of purposes, stakeholders, and related for goods or services via a DLT platform. In data) provided by the token issuer directly. regulatory frameworks. other words, the objective is for them to They can also be used to entitle the owner be used in the same way as fiat currency. to access, use or participate in an event, In the next section of our paper, we will However, most regulators have clearly service or product. In some respects, it is focus mainly on the security (investment) stated that payment tokens cannot be appropriate to think of them as a kind of token. assimilated with a fiat currency because voucher. they are not issued or backed by a central bank. They do not provide the types of Security token right, issuer claims, or access provided Tokens issued via an ICO may have an by investment or utility tokens. Moreover, investment dimension; these tokens are their value solely depends on the value that more similar to financial instruments users place in them. than they are to cash. They should be

09 Are token assets the securities of tomorrow?

Are tokens securities? How should Security Token Offerings (STO) be conducted? What does the future hold for the security value chain?

Are tokens securities? the term “negotiability” refers to how and efficient way. Here are just a handful of A security token is defined as an easy it is to do so. Securities are classed the advantages offered by STO: instrument that provides a right of as negotiable if they can be traded on • The terms and conditions/prospectus are ownership and an entitlement to a share of a regulated market, multilateral trading embedded in the security itself (called future profits or cash flows. For example, facility (MTF) or organized trading facility smart contract) a token may represent partial ownership (OTF). Tokens clearly meet this criterion for of a specific property or of a financial classification as transferable securities • Documentation and compliance instrument such as a government bond or processes (AML/KYC) are less onerous, other debt security. Standardization it is easier to exchange information with MiFID defines transferable securities as regulators transparently, and all users are Some regulators have opted to treat “classes of securities” that share certain identified instantaneously security tokens as securities in most qualities. This implies that the issued units • An admission to trading (listing) process instances. This is because they take the must share a number of characteristics so is emerging that is more automated (and view that these tokens are intended to that they can be considered a class. Most therefore fail-proof and standardized represent a promise as regards a future importantly, the claims represented by the or semi-standardized) than the listing cash flow or a claim to partial ownership of units must not be individually negotiated process for regulated markets a company. In this sense, security tokens with investors. Units must be defined are similar to traditional financial assets by common characteristics so that it is (equities, bonds, futures, options, etc.) for sufficient to refer to the type and number Overall, this is likely to reduce the time which there is clear existing legislation. of units to trade them. and cost required to launch new security offerings on the primary market and Issuers can also design tokens in a way Is the STO the security issuance enhance the compliance process. that ensures that they qualify as securities process of the future? STO also provide benefits for investors by meeting the three main criteria under A Security Token Offering (STO) is the thanks to a superior asset universe, European law: transferability, negotiability, process whereby a financial security (or enhanced liquidity (trade/post-trade) and and standardization. a digital representation of a financial fractional ownership opportunities. security) is issued in the form of a digital Transferability asset; typically the digital asset represents Transferability means that units can be ownership rights in an underlying company assigned to any other person, irrespective and/or its assets. This is entirely different to The STO represents of whether certificates exist that record the ICO discussed above, which are “utility or document the existence of the units. tokens”—i.e., digital tokens that provide an innovative Certificates are not used to prove the access to a future product/service but do existence of tokens, but tokens can not entitle the holder to ownership of an new opportunity generally be sold on secondary markets. asset or equity3. Therefore, they are typically transferable. for issuers and The STO represents an innovative new Negotiability opportunity for issuers and investors investors involved in While “transferability” refers to the mere involved in the primary market. STO can fact of passing on ownership in securities, be more organized in a more standardized the primary market

3 Node Blockchain, Securities Token Offerings, “The evolution of capital formation”, November 2018.

10 Are token assets the securities of tomorrow?

STO can be used to tokenize traditional Specifically, doing so improves debt securities and equities as well as the issuance (STO), trading a wide range of tangible assets such as (secondary market), clearing, and property, paintings, antiques, cars, digital settlement processes. artwork, IP, songs, etc. These are the From a regulatory perspective, kinds of asset that were not necessarily the status of an asset should not accessible to investors previously. In such be affected by the tokenization cases, the token or crypto-asset represents processes provided that there are a share of the underlying asset that can be no changes in the regulatory and used and exchanged over a digital network. legal status of the underlying assets. If an asset is currently regulated, using Another benefit of tokenization is that it a token to represent that asset will allows assets to be divided into smaller not change its status. Nevertheless, units so that investors can access big-ticket the nature and structure of the DLT items by acquiring a number of units of the ecosystem in which the security token assets. In practice, for certain securities exists may alter the extent to which with a high value per unit, tokenization regulations are applicable. may allow investors to buy a tenth or a hundredth of the underlying asset Practical example: and ensure its immediate replication/ At present, investors in private equity, real reconciliation with the original. estate and alternative investment funds (AIF) may find it hard to sell/transfer their Secondary trading of tokens via a holdings owing to a lack of liquidity or of “regulated platform” will also boost the organized markets. liquidity of assets and mitigate against risk by allowing investors to “take money off the If such fund holdings are converted into table” through secondary market selling. digital tokens via DLT then these can be This has the additional benefit of qualifying exchanged more easily and transactions as a recognized and instantaneous can be confirmed or validated in real time property exchange. (or nearly real time).

While the STO process mainly involves An additional benefit for investors is creating new security tokens in the context that it will be easier to move shares from of primary issuance, DLT can also be used one account to another because this to “tokenize” existing assets. will happen via DLT. This will also create an opportunity for custodians to be the Tokenization occurs when existing assets agents that transform the physical shares are recorded on a DLT platform. As we have into digital assets. In theory at least, this seen above, there are several advantages process could be used on any asset. to using tokens to represent assets.

11 Are token assets the securities of tomorrow?

Tokenization in a nutshell

Primary Market Trade Secondary Post Trade Safekeeping Notary/Issuance Market Secondary Market Custody

Tokenisation of existing Asset The tokenized assets can be Security token issued, traded STO allows tokenization of and settled on a distributed • Traded traditional debt securities or ledger are by definition held in equity but as well as a wider • Tracked cryptographically secure digital range of real assets like property, wallets. • Registered and reported Many stakeholders of the paintings, antics, cars and/or more easily digital artwork, IP, songs, etc. security value chain including The kind of assets which were regulator see DLT as a strong not necessarily accessible to opportunity to facilitate the investors before. In that case the record of ownership and the token or crypto-asset represents safekeeping of assets, by a share of the underlying asset providing a single source of truth that can be used and exchanges and by making ultimate beneficial over a digital network. ownership transparent through the life of an asset and through Security Token Offering (STO) the custody chain. In this latter A digital encryption containing all context, smart contracts will also the information pertaining to the probably enhance the processing asset and reflecting its market of corporate actions. value.

Advantages over traditional asset Point for regulatory consideration

• Security / Registry • The interoperability between ledgers

• Speed • The provision of Delivery Versus Payment in central bank money as well as the settlement • Ease of transfer finality in DLT environment • Liquidity – Enhance investors access • The legal framework related to AML/KYC, custody, to new assets safekeeping and other security definition

In the next chapters, we will take a closer look at the regulatory framework for security tokens and the business impact of security tokens throughout the security value chain.

12 Are token assets the securities of tomorrow?

What is the status quo in terms of the regulatory framework?

Crypto-assets are clearly positioned as review of the various projects/initiatives • Utility tokens, which are intended to a new asset class. As always, when an to ensure compliance with local laws provide access to a product service via innovative new solution emerges, there and other relevant EU regulations. We DLT infrastructure have been many publications and plenty of are also seeing multiple consultations • Security (investment) token, which are interest, hype and speculation in relation to (AMF), dedicated taskforces (UK), and intended to entitle the holder to a future crypto-assets, tokens, and ICO. other regulatory forums facilitated by cash flow or partial ownership of a the authorities in order to address and company Regulatory bodies have not sat idly by assess the questions at hand. while these recent changes have taken • Creation of a dedicated regulatory European regulators also recognize that place. In fact, they have published multiple framework. Malta, Switzerland, Italy and security tokens (as defined in our previous position papers, advisory documents, Luxembourg have developed and voted section) qualify as financial instruments. and recommendations aimed at industry new law provision within their respective stakeholders and investors. legal framework where the inscription As such, the criteria related to and transfer of security is recognised transferability (on a regulated market) The ongoing process of developing new within DLT (blockchain). and liquidity will trigger the application of investment token solutions means that the relevant legislation (regarding issuance, regulatory framework must be constantly • No approach defined yet. Some trade and post-trade). updated in response. In this section, we jurisdictions/authorities have not taken a will describe the approach followed by the position or publicly stated their approach Regulatory implications of security European Securities and Markets Authority yet. This does not mean there are no tokens qualifying as financial (ESMA) with regards to security tokens, regulations in place or that all crypto- instruments analyze the regulatory implications, and asset initiatives are permitted. If security tokens are to be classed as review the risks and issues regulators must financial instruments under MiFID, it is consider. In early 2019, the European regulatory important to have a clear and holistic authorities (ESMA and EBA) issued advisory understanding of the impact and Regulatory approach reports on crypto-assets. Meanwhile, local requirements applicable under all existing As highlighted in the ESMA SMSG authorities including the FCA and FINMA EU securities regulations. The range of (Securities and Markets Stakeholders have issued final reports from the crypto- legal provisions applicable to security Group) report, regulators have broadly asset taskforce and a legal framework for tokens includes (inter alia): the Prospectus/ followed one of the following three DLT has been established in Switzerland. Transparency directives, the Central approaches in relation to crypto-assets. Securities Depositories Regulation (CSDR), Abuse Regulation (MAR), UCITS, and These recent reports demonstrate that the Settlement Finality Directive (SFD), the AIFMD. However, doing so will open up new there is global consensus on the need for a European Market Infrastructure Regulation business opportunities throughout the well-defined classification system. Indeed, (EMIR), the Market Abuse Regulation (MAR), security value chain. the first step in defining a regulatory UCITS, and AIFMD. Moreover, as security framework for crypto-assets is to create • Case by case and assessment of tokens are held on a network, GDPR is likely a clear token taxonomy. While European the regulatory framework. This is to be applicable. regulators may quibble over small points the approach followed by most EU relating to wording, they unanimously jurisdictions (Austria, Belgium, Germany, The following (non-exhaustive) list contains agree that tokens can be divided into three Ireland, Luxembourg, Netherlands, some of the main impacts of regulatory main archetypes: Spain, and the United Kingdom). provisions that apply to security tokens. These countries have not prohibited • Payment (exchange) tokens, which or restricted crypto-asset initiatives are intended to be used as means of outright, but they do conduct a careful payment or value exchange

13 Are token assets the securities of tomorrow?

Regulation Topics/Markets Key Impacts (not an exhaustive list)

Prospectus/ transparency • Issuers’ obligations to investors • Depending on how the ICO/STO is structured, tokens directive may qualify as transferable securities. This would mean • Primary market that they would be required to publish a prospectus • Listing that would be subject to the approval of the competent authority.

MiFID II/MiFIR • Services related to capital markets • MiFID II are most likely to affect ICO/STO if tokens qualify as financial instruments pursuant to Art.4(1) no.15 of MiFID II

• ICO participants would be viewed as engaging in certain investment services and activities such as investing in, dealing in or advising on financial instruments (see Art.4(1) no.2 and annex I sec.A of MiFID II

Central Securities Depositories • Issuance services • Transactions must be executed by a system operator Regulation (CSDR) and (SFD) • Post trading Settlement Finality Directive • If security tokens qualify as transferable securities and (SFD) are traded on a regulated market, they will have to be recorded with an authorized CSD (CSDR)

Safekeeping and record- • Custody • No existing harmonized definition of safekeeping and keeping of securities ownership record-keeping of securities ownership at EU-level • Safekeeping • CSDR may apply in relation to notary services (initial • Notary recording of securities)

• Control of private keys may constitute a safekeeping service

• Issuers’ obligation to prevent insider • Investment tokens traded on a regulated market. No trading transposition at national level MAR and Short Selling Regulation • Primary market

• Secondary market

AIFM Directive • Alternative investment • ICO/STO may take the form of an investment vehicle and fall under AIFMD

• Issuers of security tokens may qualify as AIFM (or even management companies)

EMIR • Derivatives market • (Hybrid) security tokens may qualify under EMIR

AML/KYC • Risk of money laundering/fraud/ terrorist • Issue token via STO financing • Custodian wallets fall within the scope of AMLD

• Scope of AMLD to be incorporated by future providers of STO and exchange services for crypto-assets

14 Are token assets the securities of tomorrow?

Risks and issues regulators have yet to • On trading platforms, difficulty for We believe that consider investors to distinguish which crypto- Above, we saw how security tokens may assets fall within the scope of current the success and qualify as MiFID financial instruments and regulations and those that are not how the current regulatory requirements covered by a regulatory framework or do the development apply to these tokens. not qualify as MiFID financial instruments Nevertheless, some gaps and issues • Lack of a consistent regulatory remain and will have to be considered by of the security framework within Europe on the way the regulators in the future. These issues to approach crypto-assets that do not include the following three main factors: token will also, and qualify as MiFID financial instruments • At present, there is no European legal primarily depend framework around safekeeping and Regulatory framework in a nutshell custody services and there are some The EU regulatory framework for on, compliance differences in the legal frameworks in crypto-assets is currently undergoing place within the different jurisdictions. development and definition, but it is clear with key securities De facto, there is a lack of clarity and that the authorities intend to establish a different interpretations around the framework that will protect investors and regulations. services that may be classed asset ensure full transparency as per the existing services, custody, and safekeeping EU securities regulatory framework. within a DLT environment. New roles and responsibilities will also have to be In the next section, we will consider the defined (e.g., trustee agent for public opportunities and efficiency that can be keys) within this new framework. derived from the use of investment tokens in the security value chain. • The concepts and definition of settlement as well as settlement finality must also be We believe that the success and the assessed and clarified within a new DLT development of the security token will environment. also, and primarily depend on, compliance • Smart contracts play an important role with key securities regulations. This is in the security value chain within DLT. fundamental to winning the trust and As yet, there is no clear definition of confidence of authorities and investors and how the security and reliability of smart providing them with the transparency they contracts (and their related content) will expect. be organized. Here also, new roles and responsibilities will have to be addressed and considered by regulators.

Obviously, and as stated by the ESMA in its advisory report on crypto-assets, crypto- assets that do not qualify as MiFID financial instruments also have risk exposure—in fact, this is all the more true for this category. Amongst these issues, ESMA highlights:

• Significant risks related to fraud, cyber- attacks, and money laundering

15 Are token assets the securities of tomorrow?

Transformation of the security value chain from niche FinTech initiative to disruptive force re-shaping the securities business model

At present, we are seeing the launch of paper first and facilitate the issuance that it is building a fully integrated various projects aimed at using DLT and and distribution of these instruments. trading, settlement, and custody investment tokens as a way to revisit and infrastructure for digital assets. • Clearstream has launched a project re-shape part, or even all, of the security that aims to set up a DLT platform value chain. The Swiss and Maltese projects are to facilitate the exchange of security being run in close cooperation with the tokens representing HQLA assets in The list below includes some of the recent local regulator. They involve defining the context of securities lending and projects and initiatives that have used legal provisions and a methodology that collateral management services. DLT as part of the security value chain. will enable the new business model to • The Malta Stock Exchange has launched be organized in line with the relevant • ID2S/SETL was one of the first DLT CSD a DLT platform to organize the listing securities regulatory framework. approved by a competent authority and trading of security tokens. relevant legislation (regarding issuance, (AMF). ID2S has been granted CSD trade and post-trade). status and access to the T2S platform. • Switzerland’s stock exchange—owned The CSD aims to focus on commercial and managed by SIX—has announced

(OKEx & MSX) (OKEx & MSX) (SIX Digital Exchange) Clearstream HQLAx Project 2019 2019 2019 2018/2019

16 Are token assets the securities of tomorrow?

All of these projects as well as dedicated The Swiss and Maltese projects are token platform like Tokeny share the being run in close cooperation with the All of these projects same objectives of enabling greater local regulator. They involve defining efficiency and transparency while legal provisions and a methodology that as well as dedicated reducing transaction costs and times. will enable the new business model to These are key criteria that all members of be organized in line with the relevant token platform like the securities ecosystem (issuers, market securities regulatory framework. infrastructure operators, authorities, Tokeny share the asset services, and managers) are looking relevant legislation (regarding issuance, to prioritize. At present, we are seeing the trade and post-trade). same objectives of launch of various projects aimed at using DLT and investment tokens as a way to enabling greater revisit and re-shape part, or even all, of the security value chain. efficiency and

The list below includes some of the recent transparency projects and initiatives that have used DLT as part of the security value chain. while reducing • ID2S/SETL was one of the first DLT CSD transaction costs approved by a competent authority (AMF). ID2S has been granted CSD and times. status and access to the T2S platform. The CSD aims to focus on commercial paper first and facilitate the issuance and distribution of these instruments.

• Clearstream has launched a project that aims to set up a DLT platform to facilitate the exchange of security tokens representing HQLA assets in the context of securities lending and collateral management services.

• The Malta Stock Exchange has launched a DLT platform to organize the listing and trading of security tokens.

• Switzerland’s stock exchange—owned and managed by SIX—has announced that it is building a fully integrated trading, settlement, and custody infrastructure for digital assets.

17 Are token assets the securities of tomorrow?

Security tokens and the security value chain

The process of integrating security tokens • Compliance procedures such as AML/KYC The CSDR will remain the reference into the security value chain will probably can be executed in a more automated regulatory framework as far as notary involve several phases, each of which will way services are concerned. focus on a specific instrument or aspect of the value chain (issuance, trading, etc.) From an investor’s point of view, STO with the aim of ultimately establishing a full enable buyers to access a larger universe end-to-end security token model using a of assets. In most cases, tokens are permissioned ledger. related to “normal” securities (equity, debt, derivatives, etc.). However, depending At this stage, it might be helpful to imagine on local securities legislation, tokens can what the future may look like from an relate to digital artwork, paintings, property operational and regulatory point of view rights, etc. From an investor’s for security tokens traded within a DLT ecosystem. STO can also be used to divide underlying point of view, STO assets into smaller units and enable Issuance and listing tokens fractional ownership. This can provide enable buyers to From a process perspective investors with an opportunity to access big- STO can provide benefits both for issuers ticket items in a more affordable way and access a larger and investors. also set up a much more diversified pool of assets with a smaller capital base. universe of assets. Issuance processes have been set up in DLT in the context of FCA regulatory Finally, issuance, and specifically notary, In most cases, forums and the following benefits (among procedures in relation to new securities are others) were noted: an area in which DLT can be used to ensure tokens are related to the integrity of the token being issued • Greater transparency as regards asset versus the token issued/held in the DLT. ownership and records “normal” securities These notary/register functions will remain • A high degree of automation, removing important within the DLT ecosystem. (equity, debt, the need for registrars and nominees From a regulatory perspective • No need for reconciliation between derivatives, etc.). From a regulatory perspective, we believe network participants as they share the that the issuers of security tokens will same record of ownership However, depending still need to publish a prospectus under local law as well as in accordance with Other STO benefits also include: on local securities the European prospectus regulation. • The use of smart contracts, i.e., self- The European prospectus regulation legislation, tokens executing pieces of code that translate is applicable to securities offered to contractual terms into computational the public or admitted for trading on a can relate to digital material. This should enhance the regulated market situated or operating enforcement of contract terms and the within an EU member state. artwork, paintings, automation of back-office processes, e.g., the processing of some corporate actions property rights, etc.

18 Are token assets the securities of tomorrow?

Trading and settlement of tokens platforms offering partial or full end- be used for formal confirmation under SFD From a process perspective to-end settlement processes including and CSDR. STO can provide benefits both for issuers listing, trading, and settlement of security • On trading platforms, difficulty for and investors. tokens investors to distinguish which crypto- • This could also make it easier for SMEs assets fall within the scope of current In recent years, we have seen many to access the financial market via simpler regulations and those that are not initiatives related to setting up exchanges and faster processes, in particular when covered by a regulatory framework or do to facilitate crypto-payments. As regards smart contracts embed all dividends and not qualify as MiFID financial instruments security tokens, there is still a big gap security life cycle events in terms of the availability of regulated • Lack of a consistent regulatory secondary market infrastructure for both framework within Europe on the way From a regulatory perspective the trade and post-trade stages. The to approach crypto-assets that do not From a regulatory point of view, MiFID5 burden of regulatory compliance when qualify as MiFID financial instruments refers to transferable securities as classes setting up such ecosystems is probably a of security that are negotiable on the key reason for this gap. Safekeeping of tokens capital markets. The fact that tokens can From a process perspective be traded on exchange platforms often That said, the opportunities in this Security tokens issued, traded, and settled with significant liquidity testifies to their space are immense and regulators are on a distributed ledger are by definition negotiability. The existence of ownership convinced of the added value of DLT in held in cryptographically secure digital rights is also considered by a majority of clearing and settlement activities4. As wallets. competent authority as sufficient grounds per the ESMA report on how to apply Many stakeholders in the security value to class tokens as transferable securities. DLT to the securities market, clearing and chain, including regulators, see DLT as settlement could theoretically become an ideal opportunity to facilitate record- On the other hand, tokens can be assigned almost instantaneous with DLT, as trade keeping and the safekeeping of assets to another person irrespective of whether confirmation, affirmation, allocation, and by providing a single source of truth and certificates exist that register or document settlement could be combined into a single by making ultimate beneficial ownership the existence of the units. Setting aside step and reconciliations would become transparent throughout the lifecycle of an the liquidity and transferability that may be virtually superfluous. asset and throughout the custody chain. facilitated by DLT for a moment, we should This would in turn have a number of In this latter context, smart contracts are consider AIF funds, structured products, benefits, including reduced counterparty likely to make it easier to process corporate etc. It has always been incredibly difficult to risk (see below), and potentially reduced actions. transfer such instruments, but DLT would settlement failures and penalties. enable market participants to confirm their New roles will need to be defined and set intentions digitally and the asset could be These opportunities are fueling the up to ensure independent and trusted moved from one institution to another in development of new initiatives and projects safekeeping of private keys and other vital the blink of an eye. being launched by: wallet management services. It is therefore fair to question how the role • New entrant companies with brand new DLT security token platforms are likely of custodians and CSDs might evolve in infrastructure (Open Finance Network/ to be adapted to meet the requirements relation to security tokens managed via tZERO) of market infrastructure regulations like DLT. CSDR and EMIR. There may still be a need • Traditional financial market infrastructure From a regulatory perspective to have dual system in light of key market operators (such as the Australian Stock At present, there are no harmonized, infrastructure requirements, but within a Exchange, SIX Swiss Stock Exchange, Europe-wide definitions of security club of users, reliance on a DLT tool might London Stock Exchange, and Malta safekeeping and record-keeping in relation be enough—print outs or statements will Stock Exchange) are working on new DLT to security ownership. These tasks are

4 ESMA, “The Distributed Ledger Technology Applied to Securities Markets”, February 2018. 5 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014. 19 Are token assets the securities of tomorrow?

performed by a wide range of entities such that are not issued by government. held on the blockchain. Attempting as custodian banks, registrars, notaries, Today, the world of fiat money is in a clear to bridge between fiat currencies and depositaries, and CSDs. innovation and transformation process, cryptocurrencies, three categories of Furthermore, the rules vary according with central banks looking to provide stablecoins exist, (fiat-collateralized to the national legislation applicable to a digital alternative to cash. Central stablecoins, crypto-collateralized securities and the rights attached to banks cannot afford to be left behind by stablecoins, non-collateralized (algorithmic) securities, which are not harmonized at the current evolution and emergence stablecoins), which are all based on their EU level. Some countries may use security of new forms of payment, as they are working mechanism. tokens within DLT, whereas others will key stakeholders ensuring the risk-free Fiat-collateralized stablecoins are highly retain a requirement for physical securities. dimension and stability of payment flows regulated, centralized and must be stored within financial market infrastructures. by a trusted custodian bank, which also Payment of security token Central banks around the world have needs audits to ensure its transparency. transactions started assessing the concept of CBDC It maintains a fiat currency reserve like From a process perspective and launch announcements were made the U.S. dollar, gold, silver, as well as The efficiency of a security transaction for 2020. CBDC initiatives have even commodities like oil. heavily relies on the related payment leg. gained increasing momentum since the Crypto-collateralized stablecoins are Today, the Delivery versus Payment of a development of private-sector stablecoins. backed by other cryptocurrencies and security transaction is organized versus Among the recent initiatives, France maintain their one-to-one ratio through central bank money or commercial bank has announced they will experiment to over-collateralization. The most common money. Both central bank and commercial integrate a ‘wholesale’ CBDC into innovative form requires users to stake (vault) a bank monies are essential in the procedures for exchanging and settling certain amount of digital currencies into organization of the market infrastructures tokenized assets. Central Bank of China is smart contract, which will result in a fixed ecosystem. also known to be very active on a CBDC ratio for stablecoins. project. Non-collateralized (algorithmic) stablecoins As mentioned before, the term crypto- do not use any reserve but include a assets was primarily associated with Stablecoins working mechanism and rely on algorithms, bitcoin and other cryptocurrencies. These Stablecoins claim to stabilize the value for instance that of a central bank, to currencies were used with and have of major currencies in the volatile retain a stable price. Due to no reliance on supported the issuance and payment of crypto-asset market and are backed collateral, they are independent from any security tokens. Nevertheless, it appears by a reserve asset. They allow secure, central entities. the security market was also looking for convenient transactions without the high more stability and a less risky framework volatility that traditional cryptocurrencies Stablecoins seem to be a solution for on the security payment side. hold. Stablecoins can provide a critical financial institutions due to their simple Stablecoins and the Central Bank Digital infrastructure layer for the digital assets concept and uncomplicated transactions. Currency have emerged recently as ecosystem. The list below includes some well-known potential solutions to act as the commercial stablecoins currently on the market: bank and central bank monies of the future Additionally, stablecoins are price-stabilized • TrueUSD (TUSD) is currently the most Security DLT market. cryptocurrencies whose market price is reliable and proven stablecoin (fiat- pegged to another stable asset, which collateralized) that is fully collateralized, Central Bank Digital Currency benefits in simplicity, programmability legally protected, and transparently Central bank digital currency (CBDC, also (e.g., smart contract integration), efficiency verified by third-party attestations. called digital fiat currency) is the digital (e.g., low-to-zero transaction fees, fast It is the first asset token built on the form of fiat money (a currency established settlement times), fungibility, open (i.e., TrustToken platform — a platform to as money by government regulation or law). permissionless) access, and are less create asset-backed tokens that can CBDC differs from other crypto currencies vulnerable since no collateral is being easily be bought and sold around the

20 Are token assets the securities of tomorrow?

world. It is secured by the US dollar and banking operations, monetary policy, On top of this, keeping all assets in a uses multiple escrow accounts to reduce financial stability and legal foundations digital environment will allow/require the counterparty risk and provides token- and regulations in place. One of the main production of new data, along with new holders with legal protections against challenges will be to assess and define the data analysis and usage, and therefore new misappropriation. legal and regulatory framework not only strategies for trading, and hedging against in one jurisdiction but on a cross-border and managing risk. • DAI (SAI) is a decentralized (crypto- basis. collateralized) stablecoin built on the Open challenges Ethereum blockchain and US dollar In order to answer this challenge, six Some challenges and constraints related pegged. Its price stability is sustained central banks, comprised of the central to the market infrastructure ecosystem through a system of smart contracts, banks of Sweden, Canada, Switzerland, remain open and will need to be addressed does not rely on any banks, governments, the UK and Japan, as well as the European in the future to sustain the development or other centralized third parties, and Central Bank (ECB) and the Bank for of DLT platforms for trading and the post- can be viewed publicly on the Ethereum International Settlements (BIS) will assess trade process. blockchain. together in 2020 the “economic, functional • USD Coin (USDC) is also a crypto- and technical design choices, including At this stage, the questions of collateralized stablecoin and created by cross-border interoperability” of CBDCs. interoperability and standardization the cryptocurrency exchange Coinbase across these DLT (probably permissioned) and backed by reserves held in financial Other value-added services platforms remain open and we may see institutions. It is emitted by banks and There are obviously several areas in which a list of platforms offering no scope for focusses on the global market, currently a DLT platform and security token can interconnection. This will prevent them partnering with Goldman Sachs, Bitmain, provide added benefits for the security from fulfilling the key “distribution” criterion Blockchain Capital and others. industry. of DLT.

• Basecoin (BAB) is a price-stable DLT platforms can shorten settlement Another related challenge that may cryptocurrency (non-collateralized cycles and reduce counterparty risk determine whether or not the technology stablecoin) with an algorithmic central exposure. In turn, there may be a reduced is adopted is the ability to provide bank whose protocol is designed to need to mitigate counterparty risk Delivery versus Payment (DvP) settlement, maintain its price using the same through central clearing and the posting of in particular in central bank money. economic principles relied upon by collateral. Nevertheless, it is worth mentioning central banks around the world and its that settlement can also be facilitated in value is pegged to the US dollar. The bilateral exchange of margins could commercial bank money. possibly be accommodated via DLT for From a regulatory perspective non-OTC cleared derivatives. As we have seen, security tokens can fit The high volatility and related uncertainty For transactions that require the posting (subject to compliance with certain criteria) of some cryptocurrencies have lead to of collateral to cover counterparty risk, within the existing European regulatory a warning from competent authorities DLT could facilitate reconciliations and framework on securities. Nevertheless, in different jurisdictions, as well as the accelerate collateral movements. there is still some uncertainty related to emergence of private sector stablecoin legal aspects (local transposition of MiFID) initiatives and the central banks assessing Market liquidity may improve as a result, and regulatory gaps (safekeeping/custody) the development of fiat digital currency. although the need to have funds or assets that may block the development of DLT immediately available may exacerbate the solutions for securities unless additional From a regulatory perspective, the strain on liquidity in times of stress. regulatory definitions and requirements development of private stablecoins as well are introduced. as CBDC initiatives raises several questions related to payment systems, central

21 Are token assets the securities of tomorrow?

Security tokens—what will the securities landscape look like in the future?

Security tokens are bound to be a mainstay but the bubble would often burst or—even However, we believe this model does not of the securities services and value chain worse—chaos would ensue. do justice to the potential offered by DLT of the future: they are technologically and tokens. superior, safer and more transparent, at This model might be ideal in the case of a least for regulators. single asset, but it would be less functional This model would improve the status quo when there are many different assets at in some respects but would still be up for The current security value chain is play. Consider an investor with a diversified debate given the need to find adequate organized around a number of different portfolio of shares and bonds listed around profiles or restructure old banking/custody intermediaries that act sequentially during the globe: they may have access to one DLT systems. The benefits may nevertheless the various stages of the security lifecycle. per digital asset, potentially with little to no be significant, albeit limited to specific compatibility. This scenario means that this assets classes: notably lower collateral or The introduction of DLT into the current model is not very appealing for widespread margining. security value chain therefore represents use. It will not meet the interoperability a clear re-shaping and disruption of the criterion, which is a prerequisite for business model and of the roles of the success. regulatory framework as far as various stakeholders in the value chain. notary services are concerned.

We expect several types of business model The zoo model—small pockets of DLT to appear in the near future of the security jungles within the legacy ring-fenced value chain and market infrastructure environment landscape. Most market participants and regulators recognize the advantages that DLT will have The jungle model—disruptive DLT for the security value chain and market Theoretically, a new, open distributed infrastructure. ledger environment may be developed without intermediaries along the security It is also widely understood that the role of value chain linking issuers directly to these intermediaries (market infrastructure investors. Trading venues, CSD, CCP, custodians) is essential to guarantee and other custodian banks would be market participants’ confidence and the fundamentally disrupted by a ledger in timely execution of transactions. which participants manage the entire security value chain in real time via security An option for the future may be to use DLT and hybrid tokens. within a limited section of the security value chain for specific instruments, following the As we saw with the recent development of existing security lifecycle organized within the crypto-payment ecosystem, the model the legacy environment. may be designed to minimize the regulatory burden. This would mean that the rules This option may be useful when assessing of the game would not be entirely clear or the feasibility of the new value chain understood by investors. The concepts of technology; various regulatory forums “no limits” and a “fully open model” would supported by national competent clearly facilitate the emergence of a whole authorities are currently taking this host of new businesses in the early stages approach.

22 Are token assets the securities of tomorrow?

The nature park model—the richness of DLT wildlife hemmed in by a strong regulatory framework As so often happens, the ideal situation to aim for in the future is to be found by striking the right balance between the experience of yesterday and the innovation of today.

We believe that security tokens are the asset class of tomorrow. But to reach this point, two conditions will need to be fulfilled:

Playing by the rules of the game Without a recognized regulatory framework, the security token will not be able to develop in a sustainable adapt. • Launching new products that will be way. As discussed, the interoperability available under new distribution models of DLT across digital assets classes is Thinking outside the box (UCITS, AIF) Defining the future security value chain key to attracting widespread interest in • Leveraging legacy market infrastructure in relation to DLT is not as easy as it may the technology. All stakeholders in the and custodians that form the regulatory appear if you do not consider using DLT security value chain (investors, issuers, bedrock (trading venues, notary as just another database. Indeed, the infrastructure, regulators, etc.) need functions, etc.) as well as new roles built difficulty lies in re-shaping a sequential and to recognize security tokens within an around the reliability of the DLT network. centralized model into a distributed and (existing) regulatory framework. Security New players must be sufficiently well- shared model. tokens have to comply with the existing known to be credible and have enough transferable securities definition and the financial strength to be trusted parties. Even within the existing regulatory related regulations established over the Other stakeholders will connect or have environment, managing security tokens in a last 10 years in order to gain the trust of an account with these players. investors and regulators. These different DLT ecosystem entails: elements will ensure that there are deep • Rethinking existing roles including New entrants will have a role to play pockets in the event of failure and that traditional custody/safekeeping of assets in defining a new model through new the distance between current and future (which may disappear) technological solutions around STO, legal environments is not too large, as tokenization, smart contracts for corporate • Creating new responsibilities for trustees these deep pockets may already have actions, etc. but new entrants will also be of digital wallets and notaries in relation the necessary licenses to operate and required to fulfill new roles as independent to token environments and existing the standing to put their money on the trusted agents and to provide assurance as assets, etc. (these will appear) line. The only issue is ensuring that often- regards digital wallets and smart contracts. outdated systems are nimble enough to

23 Are token assets the securities of tomorrow?

Conclusion

Security tokens are bound to be a initiative is also in line with the recent mainstay of the future security value private stablecoins initiatives as an answer chain landscape. The opportunities they to the high volatility of the legacy crypto offer will help the industry to re-shape currencies. an environment that will provide greater efficacy and transparency as regards the Security tokens and DLT platforms require security issuance, trading, and post-trading a new approach and a shift in mindset processes. as we envisage the security value chain moving away from a centralized approach We have drawn readers’ attention to the with various intermediaries and towards a importance of having a clear definition and distributed platform with instant sharing of understanding of crypto-assets. Indeed, information and data. the related regulatory impact can be vastly different if we are talking about a crypto- This new approach will probably disrupt payment token as opposed to a security current stakeholder roles and also prompt token. the development of new ones. We are currently seeing more and more innovative Security tokens are globally recognized models and new entrants in the securities by academics and security authorities as landscape. securities and consequently these security tokens will fall under European securities Nevertheless, local regulatory regulations including the prospectus requirements and inherent expertise regulation, MiFID, EMIR, CSDR, MAR, UCITS, will provide scope for existing market and/or AIFMD. infrastructure to play a key role in the establishment of the new DLT ecosystem. Naturally, issuers may still design tokens to bypass or not comply with the security Some challenges and constraints remain definition provided by European securities if we are to set up a safe and trusted regulations in order to reduce compliance DLT environment for security tokens. costs. Nevertheless, it would be an error to bypass the opportunities that security Nevertheless, we believe that the success tokens and DLT offer for each stakeholder and sustainable development of security in the security value chain in terms of tokens and related DLT platforms will efficiency and reduced operating costs. mainly rely on their compliance with the key principles expounded in the existing Strong and sustainable development of securities regulations. This is essential to security tokens in DLT will rely on a strong gain the trust and confidence of investors and well-balanced ecosystem coupled and regulators. with a strong, well-defined regulatory framework and compliance with it; a new Central Banks have also clearly understood approach and innovative mindset from that the business needs to properly new entrants; and expertise and know- address the payment side of the security how from existing market infrastructure transaction with the design and foreseen operators. implementation of Central Bank Digital Currency (CBDC). The Central Banks

24 Contacts

Laurent Collet Pascal Martino Partner | Strategy Regulatory & Finance Partner | Banking Leader + 352 451 452 112 +352 451 452 119 [email protected] [email protected]

Patrick Laurent Thibault Chollet Partner | Technology & Innovation Leader Director | Technology & Enterprise Applications +352 451 454 170 +352 451 452 656 [email protected] [email protected]

Biba Homsy Benoit Sauvage Board Member | Letzblock Luxembourg Blockchain Director | RegWatch, Strategy and Consulting Association +352 451 454 220 www.letzblock.com [email protected]

Simon Ramos Partner | IM Advisory & Consulting Leader +352 451 452 702 [email protected]

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited (“DTTL”), its global network of member firms, and their related entities. DTTL (also referred to as “Deloitte Global”) and each of its member firms are legally separate and independent entities. DTTL does not provide services to clients. Please see www.deloitte.com/about to learn more.

Deloitte is a leading global provider of audit and assurance, consulting, financial advisory, risk advisory, tax and related services. Our network of member firms in more than 150 countries and territories serves four out of five Fortune Global 500® companies. Learn how Deloitte’s approximately 286,000 people make an impact that matters at www.deloitte.com.

This communication contains general information only, and none of Deloitte Touche Tohmatsu Limited, its member firms or their related entities (collectively, the “Deloitte network”) is, by means of this communication, rendering professional advice or services. Before making any decision or taking any action that may affect your finances or your business, you should consult a qualified professional adviser. No entity in the Deloitte network shall be responsible for any loss whatsoever sustained by any person who relies on this communication.